You talk too much
You worry me to death
You talk too much
You even worry my pet
- Joe Jones and Reginald Hall
Suddenly U.S. finance is all about talk, some of it threatening to investors.
And there is absolutely nothing to be done about this, in the age of YouTube. Outrageous talk is the new normal. In this past week serious men have said the following:
- Chinese monetary policy is in the hands of megalomaniacs who want to rule the world.
- Chinese policy-makers are "a little rough around the edges," but Chinese financiers mean well and will become more proficient. Then they will rule the world.
- The Chinese economy is about to implode and end world prosperity.
- Negative interest rates are the solution to the monetary policy problems of the globe.
- Negative interest rates are destroying the economies where they are employed by policy-makers.
- The large U.S. banks should be converted to public utilities.
In the age of the internet, every loony thing that a financier in a position of authority says will go viral and appear a bazillion times in the Twitterverse. There, looney is far more popular than reasoned and sensible. And out-of-context is the only way to be taken.
A particularly provocative speech was made this week by Neel Kashkari, the newest Federal Reserve Bank President of the Minneapolis Fed. Today's district Federal Reserve Bank Presidents are products of the internet age. They give more speeches. They view these speeches as central to their function. And the point of the speeches is not to form consensus, but to affect opinion. In Kashkari's words, "If I am not willing to stand up and share my concerns, I am not doing my job."
Kashkari noted that his speech was not vetted in Washington. This is the post-Crisis Fed. There are going to be multiple Fed speeches taking multiple positions on every side of any matter important to financial markets. And Fed presidents are becoming more focused on personal belief and less about consensus.
But this particular speech concerns me, because of the immense impact its policy prescriptions could have on the U.S. economy and global finance, and because Kashkari is far from alone. The speech was short on specifics, but Kashkari definitely advocated government decisions rather than market decisions. Possibilities he proposed included breaking up the large banks or nationalizing them.
Bank bashing is playing very well on the campaign trail. Taking the banks to task is Bernie Sanders' principal issue. There is nobody from either party defending financial institutions, including Senator Cruz, a Republican candidate, whose wife works for Goldman Sachs.
Mr. Market listens. He seems to frown on the future of the large banks, lately. Perhaps because the travelers on the campaign trail seem to plan revenge upon the banks being blamed for the Crisis. This speech, to the extent that it is taken seriously, will reduce market valuations of Bank of America (NYSE: BAC), Citigroup (NYSE: C), Goldman Sachs (NYSE: GS), JPMorgan Chase (NYSE: JPM) and Morgan Stanley (NYSE: MS).
I consider two issues raised by the Kashkari proposal to intervene in the management of the dealer banks.
- The likely effects of splitting up the banks.
- How the U.S. Government will handle the clearing of interest rate swaps, if it acquires sole responsibility for the job.
Splitting up the banks. This issue is not without its advocates in the market (including me.) But to advocates like me, splitting the banks is a market issue. A market-determined division of a large bank would be less likely to throw out the creative baby with the destructive bathwater.
I find it useful to remember that this is not the first time that the government has considered dividing the large banks. JPMorgan and Co. was divided into JPMorgan and Co. and Morgan Stanley during the depression. It is useful, and ironic, to recall that the division was by separating the commercial bank from the investment bank. Now, 100 years later, they are two of our largest banks, and they are both combined investment and commercial banks. I'm not sure how breaking up banks and letting them recombine improves their efficiency.
What is the plan when $200 trillion in cleared global derivatives fall into the government's lap?
I am also interested in what nationalizing U.S. dealer banks would do to resolve one of the dealer's thorniest problems, the OTC derivatives markets.
The government has fixed the derivatives markets once so far. The result is the OTC clearing counterparties. While there is a good case that clearing plain vanilla interest rate swaps has reduced global exposure to potential damage from this source, there is also a good case that private sector, less heavy-handed, solutions might be substantially better. In particular, the exemption of OTC derivatives from bankruptcy law will, if not repaired, likely erode the value of banking debt as the implications of the bankruptcy exemption play themselves out in the marketplace for bank debt.
And the biggest problem that derivatives create continues to grow. This problem is that the market does not value OTC derivatives portfolios. The staff of the exchanges make estimates of value of cleared derivatives. Bilateral derivatives are valued internally. We have no visibility on the value of bilateral derivatives. And there is no doubt that the exchange estimates are not what a market for the instruments would charge. The CME and the London OTC clearing house, LCH:Clearnet, both value the same OTC interest rate swaps. Market participants find that the values differ - sometimes by several million dollars for a single interest rate swap.
In fact, the dealers may be too small, too few, and too conservative to manage the derivatives risks of the near future. I have recently written of my concern for the health of the large European dealer banks. The focus of the article, "The Disaster of European Financial Markets' Delay and Inaction" was the general dysfunctionality of European Finance. These European dealers are all scaling back their derivatives activities, potentially leaving the U.S. banks alone in the business.
Competition is live and well among global dealer banks. Quality is still rewarded. Deutsche Bank was provided as an example of a poorly performing European Bank. The graph below compares performance of two of the weakest global banks, Deutsche Bank (NYSEARCA: DB) and Credit Suisse (NYSE:CS) with two of the strongest, Bank of America and Goldman Sachs.
There are only four remaining U.S. dealer banks, who clear 90%+ of the cleared U.S. interest rate swaps; the European dealers, on the other hand, are all reducing the size and scope of their dealing operations. Are four U.S. dealers enough to clear the world's $200+ trillion of cleared interest rate swaps? Would the problem be smaller if all four banks were nationalized by the United States? The membership of the Clearing House would certainly be smaller. One member. Would Clearing OTC swaps in London, in a French-owned exchange, be the United States' government's responsibility?
The chart below shows that dealer banks are definitely living in a competitive environment.
As the chart shows, these banks are not the captives of history. There is success and reward; failure and punishment. Government-owned banking utilities, by contrast, would not be rewarded or punished.
While relative performance of individual government-managed banks would no longer be an issue; the same could not be said of the banking system. What will happen, almost certainly, are two parallel systems. Banks that take risks without penalties, as do the many European "zombie" banks - failed banks that, due to the knowledge that the government will step in if necessary, continue to function with impunity. And smaller banks, with riskier debt, forced to compete with government behemoths. How would that be prevented in a nationalized system?
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.